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October 8, 2012

What’s Next for the Growth of ETFs?

Advisors are looking for finer slices of capital markets, as well as better beta and alternative weighting methodologies for gaining exposure to market segments

The global exchange traded product (“ETP”) industry has enjoyed stellar growth over the last 10 years, with an asset compound annual growth rate (CAGR) of roughly 29%. Currently the global ETP industry has over $1.76 trillion in AUM, 70% of which is in the U.S. (roughly $1.2 trillion). In the U.S. alone, there are over 1,400 different ETPs, the majority of which are ETFs.[1] Although the rate of growth is likely to slow, we continue to believe that there will be continued product innovation and broader adoption of ETFs by advisors.

In fact, Cerulli Associates has speculated that global AUM could exceed $3.5 trillion in the next five years.[2] There are a couple of trends that will likely fuel continued growth. We believe that the growth drivers will be: product Innovation, broader adoption by advisors, and the growth of model builders. Each of these growth drivers are covered in greater detail below.

Product Innovation

First and foremost, I believe that there will be continued product innovation. The first phase of ETF growth came from providers offering “cheap beta” solutions. These were generally strategies designed to mimic the broad market indexes in a cost-effective manner. The next wave of growth will likely come from gaining access to unique market segments (i.e., China, commodities, currencies, etc.), “Better Beta” strategies (i.e., improving upon the traditional market benchmarks) and broadening of fixed income options.

Advisors are demanding finer slices of the capital markets, and access to unique market segments. Not all can be efficiently accessed via an ETF structure, but increased demand will lead to more innovation in inefficient markets or asset classes. For example, it would be difficult for the average investor to determine what securities to buy in China; therefore, an ETF may provide the most efficient way of accessing the market.

In the area of better beta, advisors are seeking alternative weighting methodologies, as a means of gaining exposure to market segments. There has been a lot of academic research evaluating alternative weighting methodologies like “equal weight” and “fundamentally weighted” strategies. Rather than the traditional cap-weighted strategies that overweight the largest constituents and underweight the smaller constituents, equal weight strategies allow each constituent to contribute equally from a risk-return perspective. Research has shown that many of these alternative weighting methodologies have outperformed their cap-weighted equivalents over longer intervals.

Fixed income ETFs are still relatively new. The first fixed income ETF was launched in 2002, and the growth of this ETF type has accelerated over the last several years. As of August 31st, U.S. Fixed Income ETF AUM was just shy of $230 billion1. As advisors find it increasingly challenging to buy individual bonds, they have begun to embrace fixed income ETFs as viable options. Fixed income ETFs are now available in investment grade, municipal, high yield, short-duration, aggregate and emerging markets.

Fixed income ETFs are now also available in a defined-maturity structure. Defined-maturity ETFs combine the benefits of individual bonds, and bond funds, in a transparent and tradable structure. Defined-maturity ETFs are a fixed-term structure. At each fund’s respective maturity date, the fund will make a cash distribution to the current shareholders of its net assets after making appropriate provisions for any liabilities of the fund. Defined-maturity ETFs combine the benefits of individual bonds, bond funds and traditional fixed income ETFs. These strategies allow advisors to manage to their client’s personalized and precise needs. Advisors can use defined-maturity ETFs as part of a laddering strategy, or they can match the defined-maturity ETF to their client’s specific cash flow needs.

Broader Adoption by Advisors

ETF usage continues to expand as more advisors embrace the cost-effective structure. According to a 2011 Charles Schwab / ETF Trends study, 85% of the RIAs using the Schwab platform held ETFs in their clients’ portfolios. In fact, the usage increased based on the size of the RIA firm, with 100% of the largest segment ($1 billion or more in AUM) using ETFs. Their study points to dramatic increase in the flows of fixed income ETFs (from 31% in ’10 to 54% in ‘11).[3]

In addition to the RIA growth referenced above, many advisors at the large wirehouses have converted their business models to Discretionary Platforms (also known as “Rep-as-PM”). These platforms allow advisor to mirror the firm’s recommended asset allocation models, or to incorporate their own views, in a more scalable business model. ETFs represent an efficient means of gaining broad-based exposure to the market segments. Advisors can also be more nimble incorporating changes due to the tradability of ETFs.

The Growth of Model Builders

Another growth engine for the ETF business has been the emergence of Model Builders. Model Builders are typically RIAs who offer their capabilities to clients and other RIAs. They have clearly defined investment disciplines, and often run multiple models. In 2011, Morningstar began to track the Model Builders. According to their September 2012 ETF Managed Portfolios Landscape Report, Morningstar is currently tracking over 490 strategies from 120 firms with collective assets under advisement of $50 billion (as of June 2012). Morningstar estimates that these strategies have grown 30% year-to-date, and 48% since September 2011 through June 2012.[4]

The growth in model builders has been fueled by a number of factors: the fiduciary standards, access to institutional quality portfolio management and scale. We see similarities to the growth in ETF Model Builders to that of the growth of the Separately Managed Account (SMA) business. Like their SMA counterparts, each Model Builder has a clearly defined investment discipline. They possess an investment expertise, and offer strategies to others who seek their expertise. Many firms offer multiple models.

I believe that the growth in Model Builders will accelerate as firms develop their track records, and focus on promoting their strategies. Model Builders will begin to focus on distribution opportunities with ETF Sponsors, TAMPS and third-party marketing organizations.

Conclusion

I believe that ETFs will continue to evolve and grow over time. Growth will likely come from product innovation, broader acceptance from advisors, and the growth of model builders. How large and how fast the growth will be is debatable. However, what seems abundantly clear is the ever expanding role of ETFs in building better client portfolios. ETFs provide access to virtually every market segment, in a cost-effective and tax-efficient manner. ETFs represent a key evolutionary development in the growth of the Asset Management industry.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investment involves risks.

This material contains the opinions of the author but not necessarily those of Guggenheim Investments and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. There is no guarantee that results will be achieved. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.